Market News

January 16, 2012  Mon 4:45 AM CT

As I discussed in a  recent column, good professional traders don't view things in isolation. They often trade one stock against another, one asset class against another, or implied volatility against historical volatility.

They also trade against other traders, buying something that they think is undervalued and selling something they think is overvalued--at least on a relative basis. And that is why this type of trading is sometimes known as relative-value trading.

We wrote of one such trade in an option play in two homebuilders, Toll Brothers and KB Home, on Dec. 20. A trader bought roughly 11,000 February 20 calls in TOLL and sold more than 21,000 KBH January 7.50 puts.

There are several moving parts here, but the trader had a neutral or bullish view on KBH and a neutral or bearish view on TOL as both popped higher. At the same time, the trader was selling volatility in the two names, thinking that their actual volatility would fall. (See our Education section)

The TOL calls were sold for $1.40, and a week later they were worth $1. The KBH puts were sold for $0.48 and were worth $1.30 a week later, so they were trading at a fairly sizable loss. At the time of this writing, the drop in KBH was twice the drop in TOL, with the former down some 3 percent and the actual volatility clearly on the rise. So the trader's original assumptions last week were proving false.

This is a good example of the fact that even professionals don't get all their trades right. Relative-value trading can be an excellent way to approach the market, but it is hardly foolproof. And for retail traders, the biggest problem is that such strategies can be very expensive.

One alternative to consider is the Nasdaq OMX Alpha Index Options. These allow you to trade an individual stock against an index with one option.

For example, if you think that Apple will outperform the overall market, you could buy a call on the index that pits AAPL versus the SPDR S&P 500 exchange-traded fund. With this trade, You could profit if Apple outperforms the market but also make money even if AAPL goes down, so long as it doesn't fall as much as the SPY.

These options are new and don't have much volume, however, so the spreads are still pretty wide. It is also difficult to determine their proper volatility premium, though a quick look suggests that selling strategies may be a good place to start.

True relative-value strategies are hard to do effectively for retail traders, but thinking in this way is very useful. Viewing a prospective trade in a broader context--not in isolation--is a key to success.

We see this in the VIX all the time. People rattle off the spot VIX reading in isolation and complain that it doesn't tell us much. They are right, but looking at volatility readings in context is very useful. The same is true with all other types of trading.

(A version of this article appeared in optionMONSTER's What's the Trade? newsletter of Dec. 28.)
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